Gold stocks remain very cheap relative to gold

After updating my gold-seasonality research last week, I heard from traders wondering how it affects gold stocks. Since the price of gold is their primary driver, gold seasonality naturally has a major impact on gold-stock price levels. This is readily apparent in the seasonality of the HUI, the flagship gold-stock index. As you’d expect, this sector mirrors and amplifies the seasonal swings in the metal it mines.

Four weeks ago I wrote about oversold gold stocks that had been pushed down to near panic levels. I wrote: ‘The result is very cheap gold stocks today, great bargains. Relative to gold, they’ve been hammered back down near panic levels.’ And included the table below of a sample of Australian gold stocks:

Atlhough still well off levels seen three months ago, since then gold stocks have had a good run. This can be seen from the updated table below with the ten sample gold stocks averaging a 4.7% gain over the month. This is compared to a less than 1% gain for the All Ords. (And had we looked at prices last week, several of the stocks below were showing even stronger gains). Of these ten gold stocks, four were lower with three of these only marginally down (0.7%, 1.7% and 2.1%). The only real loser was Tribune, down 6.7%. Standouts were St Barbara and Resolute, up 17.1% and 22.5% respectively in just four weeks.

Company

Code

Share Price

% change over four weeks

Alacer Gold

AQG

$10.62

+3.5%

Carrick Gold

CRK

$0.40

+2.6%

Kula Gold

KGD

$1.39

-2.1%

Newcrest Mining

NCM

$35.85

+7.7%

Oceana Gold

OGC

$2.24

+4.7%

Perseus Mining

PRU

$2.98

-0.7%

Ramelius

RMS

$1.16

-1.7%

Resolute

RSG

$1.96

+22.5%

St Barbara

SBM

$2.40

+17.1%

Tribune

TBR

$2.10

-6.7%

As at 18/11/2011

Gold’s seasonality is demand-driven. Throughout much of the calendar year, various income-cycle and cultural factors around the world drive outsized spikes in gold demand. After discussing these in depth in last week’s article on gold bull seasonals, there’s no need to rehash them here (you can read last week’s article here). But while gold’s demand varies radically over a calendar year, its mined supply is almost perfectly inelastic.

Gold’s newly-mined supply flows into the markets at an essentially-constant rate. It generally takes over a decade between finding a new deposit to building an operating mine. Plenty of time-consuming steps slow this process, from drilling to define the ore body to securing permitting to arranging financing to ordering long-lead-time equipment to scheduling construction. This process simply can’t be rushed.

And once a gold mine is operational, its ore can only be extracted and processed at a certain rate pre-defined in the pre-construction engineering process. It doesn’t matter if the gold price rockets an order of magnitude higher tomorrow. There is generally no way to increase gold production at operating mines that doesn’t necessitate huge capital investments and new construction over a multi-year time span.

Since global gold supply simply can’t be ramped up to meet seasonal demand spikes, the only possible economic outcome is for the gold price to be bid higher. An essentially-fixed supply is temporarily overwhelmed by surging demand, forcing the capital flowing into gold to compete for this scarce resource. This dynamic drives gold seasonals, which are then mirrored and amplified by the gold stocks.

The best way to understand gold-stock seasonality is through the lens of this sector’s primary index, now known as the NYSE Arca Gold BUGS Index. A clever play on the somewhat-disparaging gold-bug label, BUGS stands for Basket of Unhedged Gold Stocks. The 16 major gold miners now included in this index are collectively responsible for the majority of global gold mining today. It is better known by its symbol, HUI. And born in 1996, it has been around for today’s entire secular gold bull.

Naturally for this HUI-seasonality research, I use the same methodology from my gold-seasonality work. It deviates from conventional seasonal analysis, which often considers 30-year blocks of time. The problem with such long spans is they encompass secular bulls and bears alike. Yet prices behave very differently in bulls and bears, as all speculators and investors know. So if seasonality is to be used as a gold-stock-bull trading tool, it is logical to limit the data fed into it to gold-stock-bull years.

And of course as any bull market marches higher, its prevailing price levels gradually rise. So far this year, the HUI has averaged 553. This is 9x higher than its 2001 average of 60! A 5-point move back then was gargantuan, but the same today is trivial. So in order to make every year comparable, we have to individually index each year’s HUI action. This makes all years perfectly comparable in percentage terms.

My indexing methodology is simple. The first trading day of each calendar year (or month for the second chart) is recast at 100. Then the rest of that year’s daily HUI action in percentage terms is rendered off that common base. If the HUI climbs 10% in any year, no matter what its absolute level, this index rises to 110. If it falls 10%, its index goes to 90. Averaging all these individual annual indexes together yields this fascinating chart of HUI bull seasonals.

In order to sync this chart up with last week’s gold version, I made one major change. 2000 was rolled off. Gold’s secular bull started in April 2001, but the HUI actually bottomed in mid-November 2000 which heralded the birth of its own secular bull. But despite that early start, 2000 definitely wasn’t a gold-stock-bull year. It was 46 weeks of a maturing gold-stock secular bear, with only 6 short weeks of a young bull.

Between 2001 and 2011, the HUI gold-stock index enjoyed utterly-amazing average returns. By the end of each calendar year, on average the HUI had soared 35% higher! This is phenomenal during a secular stock bear where the general stock markets were dead flat at best over this past decade. The HUI carved a strong seasonal uptrend over this span, with definite support and resistance lines you can see above.

Not surprisingly since the price of gold ultimately drives gold-miner profits and hence their stock prices, these HUI seasonals closely mirror gold’s. Just like gold, the strongest time of the year for gold stocks is between autumn and spring. And just like gold, this sector’s weakest time of the year is the dreaded summer doldrums. Gold stocks also surge in major seasonal rallies that coincide with gold’s own.

The first one launches from seasonal lows in mid-March, the same time gold’s own initial seasonal rally starts marching higher. You may want to open a second browser window with last week’s gold-bull-seasonals charts to better understand and internalize this relationship. While gold tends to climb 5.1% higher on average by mid-May, the HUI’s first big seasonal rally powers 15.4% higher by late May. This is really impressive 3-to-1 leverage to the price of gold, which is the reason why traders like gold stocks.

The HUI peaking a couple weeks later than gold in May is probably due to psychological momentum. After a strong gold-stock rally, speculators and investors are getting greedy and overly-optimistic about gold stocks. So even after gold initially weakens, they tend to suspect it is merely a minor pullback and continue to buy aggressively. But then when the summer doldrums really hit in early June and the gold selling accelerates, the gold stocks are finally dumped aggressively.

Thanks to 2011’s wildly-anomalous mid-year gold rally, gold’s own seasonal low in the summer was pulled back considerably from late July to early June. But the HUI’s mid-year seasonal low remains right where it was in the last iteration of this research, in late July. This will likely continue to be a better time to deploy capital in gold stocks going forward, as this sector really tends to weaken during mid-year. So despite gold’s new earlier seasonal low, I am still going to favour late July for gold-stock deployments.

After that mid-year doldrums washout, the HUI’s second big seasonal rally starts marching higher. This catapults the flagship gold-stock index 14.5% higher on average by mid-September. These are impressive gains considering gold’s own parallel seasonal rally, which now starts over a month earlier, only sees 7.4% gains on average. The HUI’s mid- to late-year seasonality exhibits healthy 2-to-1 leverage to the gold price.

Interestingly gold’s seasonal peak is a few weeks later than the HUI’s, in early October compared to mid-September. The likely explanation is after the gold stocks have surged so far so fast in just a couple months, speculators are anxious to realize profits. They can sell high on a short-term basis before buying back in lower at the HUI’s next major seasonal low, which soon mirrors gold’s in the latter half of October.

The HUI again slumps to its seasonal support then, although it doesn’t knife below it like in late July. This late-October timeframe is one of the best times of the year seasonally to buy gold stocks, as they are on the verge of a massive seasonal rally. It powers a staggering 19.9% higher on average between late October and late February! Just like for gold, this is the HUI’s strongest seasonal rally of the year. Once again the HUI’s average 19.9% gain over this span nearly doubles gold’s 10.4%.

After that there is a minor pullback back down to seasonal support in early March, and then this whole cycle begins anew. Understanding the gold stocks’ seasonality offers some great trading cues to speculators and investors alike. If you want to increase your odds of buying new gold-stock positions at relatively-low prices, consider deploying in mid-March, late July, or late October. These are the crucial times when the HUI seasonals retreat back to, or even fall under, their uptrend’s support line.

And if you want to improve your chances of selling existing gold-stock positions at relatively-high prices, the best times to do it are as these major seasonal rallies are maturing. We are talking late February, late May, and mid-September. While the HUI certainly doesn’t always follow its well-established seasonal pattern precisely, a decade’s worth of secular-bull price action is pretty compelling to consider before trading. It helps traders better understand the most-likely times to buy low and sell high within any year.

This second chart digs a little deeper into HUI bull seasonality by ratcheting up the resolution to monthly. Each calendar month is individually indexed and then averaged over the gold stocks’ 2001-to-2011 secular-bull span. This alternative view highlights some intra-month insights not readily apparent in the full-year seasonality above. It also reveals what the best months of the year to own gold stocks are.

They happen to be November, May, August, and December. On average since 2001, the HUI has surged 8.6%, 7.9%, 5.9%, and 5.0% higher in these particular months. The only surprise is August, which wasn’t as strong in past iterations of this research. One key factor contributed to this. The August 2000 now rolled off the average had a modest 2.2% gain in the HUI, while the latest August 2011 now included saw a massive 10.1% HUI surge driven by a major gold rally.

This cements the importance going forward of looking to late July as a major buying opportunity in gold stocks, so traders don’t miss out on the strong August seasonality. And the other two major seasonal buying ops are as readily apparent in these monthly seasonals as they were in the annual seasonals above, mid-March and late October. These are the best times of the year seasonally to add new positions in gold stocks, when the odds for an imminent major rally are the most stacked in your favour.

While HUI bull seasonality is certainly an interesting thread of research, the usual big seasonality caveat still applies. No matter what price you are studying, seasonality is always a secondary driver. The primary driver of all short-term price action is sentiment, the collective greed and fear of traders actively participating in that particular market. When either of these perpetually-warring emotions hits an unsustainable extreme, it easily overrides seasonality for a spell until that excess is rebalanced away.

And we just witnessed a perfect example. Despite the HUI being in the midst of a major seasonal rally in mid-August 2011, gold was getting really overbought at that point. I wrote a hardcore contrarian article on this right when gold was topping, warning that the excessive greed and euphoria plaguing it would lead to an imminent major correction. Even gold itself was in the midst of a major seasonal rally at that point.

And indeed gold’s extreme overboughtness couldn’t be sustained, it corrected rather sharply in the following weeks in spite of strong seasonals. And of course as the gold stocks’ primary driver, it easily dragged down the HUI with it. The key lesson here is not to trade on seasonals independent of considering technicals and sentiment. An overbought price is still likely to correct no matter how strong its seasonals happen to be, while an oversold one is still likely to rally even if its seasonals are weak then.

Think of seasonals like prevailing winds. As all pilots know, a tailwind is far preferable to a headwind. Even though an airplane’s engines are its primary driver, bucking a headwind leads to a slower trip that consumes considerably more fuel. But a tailwind makes the same journey faster and more economical. Favourable seasonals are like a tailwind, providing an additional bullish boost to prices as long as they aren’t overbought and sentiment isn’t too greedy yet.

And in the case of gold stocks today, both conditions are true. Trading down near its 200-day moving average, the HUI is nowhere close to being overbought. And far from being greedy, traders are actually pretty apathetic towards gold stocks today. And this is certainly understandable since the HUI has merely been grinding sideways on balance for an entire year now. It hasn’t advanced much at all in 2011.

Nevertheless, as I wrote in late October right at the best seasonal buying opportunity of the year, gold stocks remain very cheap relative to gold. Fundamentally if anything they are very oversold, languishing at prices that reflect gold prices far lower than today’s prevailing ones. So the seasonal tailwinds we now enjoy entering this strongest time of the year for gold stocks are very bullish given this sector’s technical, sentimental, and fundamental backdrop.

The bottom line is the strong demand-driven gold seasonality naturally drives parallel seasonality in the gold stocks. They mirror and amplify the seasonal rallies and slumps in the metal that ultimately drives their profits and hence stock prices. Gold-stock traders can use this sector’s seasonality to increase their odds of buying relatively low and selling relatively high within a calendar year. It’s a valuable trading tool.

But as always seasonality is merely a secondary driver, subordinate to sentiment and technicals. Strong seasonality won’t propel already-overbought prices higher, nor will weak seasonality retard oversold ones from rallying. Thankfully this year as we enter gold stocks’ strongest seasonal rally, they are far from overbought and few traders are excited about their potential. So today’s seasonal tailwinds are very bullish for the coming months.